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The golden mean

20 October 2015

Tye Bousada of EdgePoint points out that market volatility is an unwelcome, but necessary, component of long-term investment returns.

Over the last 89 years, the S&P 500 index has averaged an annual compound return of approximately 10%. The return in any given year, however, is very rarely anywhere close to that. In fact, annual returns are all over the map. If the average return is 10%, how is it that when investors look at their statements they may see an annual return of -3% one year and +17% another? The simple answer is: it takes those fluctuating annual returns to create that average return.

Some investors interpret an average return of 10% to mean that they can expect their returns to go straight up and stay around that average. The reality is that market returns are typically very volatile. Returns will be much higher and much lower than the average throughout the years. It’s the lower-than-average years that cause investors the most distress and it’s this volatility that creates the market conditions for those average returns.

Average returns are rarer than you think

Source: Bloombergview.com; the chart shows the distribution of returns of the S&P 500 index going back to 1926

Unfortunately for investors, volatility flies in the face of certainty and predictability which, as humans, is something we crave. Investors who try to impose certainty onto a predictably unpredictable market get caught up in the noise and forecasts and believe they see trends and patterns that will allow them to time the market. Buoyed by innumerable experts touting their supposed knowledge of when and where to invest, investors gain a false sense of confidence and refuse to acknowledge that nobody knows for certain what the markets will do on any given day, week or year. Unable to accept the futility of market timing, investors end up buying and selling at exactly the wrong times.

Ignore the noise

A well-known study1 on investor returns consistently shows that investors who attempt to time their market entries and exits rarely succeed, resulting in average returns of just 2.8% a year.

This is largely because there’s an underlying assumption that the market is one cohesive organism. The reality is that ‘the market’ is a huge collection of very different businesses in a lot of different industries, with different balance sheets, different management teams, different growth opportunities, different competitors, different valuations and so on. Trying to determine what one business will do in a given year is challenging enough, but attempting to do it for the whole market is impossible even for the most savvy investor.

So where do investors go from here? For once there’s a simple answer: there really is no perfect time to invest. As soon as investors accept that trying to time the market is useless, they are left with a relatively straightforward path to navigating the market; namely, when they have money to invest for the long term, they should invest it. When the markets go through periods of volatility, they should stay invested because it matters less when they invest – just that they do invest. It won’t be easy, but the decision to hold steady makes an investor more likely to move from below-average returns to average (or even above-average) returns over the long term.

Average returns are rarer than the moniker implies. There is no straight line to 10%. Volatility is a necessary ingredient for positive returns because, among other things, it creates opportunities to buy good businesses on sale as other investors flee the market during downturns. Embracing this notion should go a long way in alleviating the fear and anguish investors feel when they experience volatility and increase their chances of experiencing average market returns.

1 Dalbar’s Quantitative Analysis of Investor Behavior; 20-year annualised returns by asset class in US$, 1994–2014. The average investor return is the average of equity, fixed income and asset allocation.

Tye Bousada of EdgePoint is a co-manager of the St. James’s Place Global Equity fund. The opinions expressed are those of Tye Bousada and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

Please be aware that past performance is not indicative of future performance. The value of an investment with St. James’s Place may fall as well as rise. You may get back less than you invested. Returns on equities cannot be guaranteed.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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